The Rise of the Dinosaurs: Legacy Software Firms and the AI-Driven Boom
There’s a curious trend happening in the world of tech: legacy software firms, the companies often seen as dinosaurs of the industry, are experiencing a dramatic resurgence in valuations. This phenomenon is best illustrated by the recent surge in SAP’s share price, topping $200 for the first time in the company’s history. Founded in 1972, SAP now boasts a valuation exceeding $234 billion, a whopping 50% increase in just the past year. This remarkable growth isn’t just a blip; it’s part of a broader narrative where companies like Oracle and IBM, both established decades ago, are also seeing their valuations soar.
While market valuations aren’t a perfect reflection of a company’s health, they’re a valuable gauge of investor confidence, often tied to both a company’s financial performance and its ability to adapt and innovate with the times. So, what’s driving this unexpected boom? The answer lies in a combination of factors, but one stands out: the rise of artificial intelligence (AI).
The Cloud & AI Convergence: A Game Changer
Traditionally, these legacy software firms thrived on a license model, selling their products to companies on-premises. However, as the cloud computing revolution gained momentum, these companies faced the need to adapt. "Old SAP," as it were, found itself in a difficult position, needing to bridge a gap between its established on-premises customer base and the burgeoning demand for cloud-based solutions.
This challenge became the crux of CEO Christian Klein’s turnaround strategy since 2020. His focus shifted to helping customers transition to the cloud, while simultaneously forging critical partnerships with hyperscalers like Google and Nvidia. These strategic moves haven’t gone unnoticed, with SAP’s cloud revenue experiencing a remarkable 24% year-on-year growth in Q1 2024, propelled by its "cloud backlog" pipeline and the infusion of "business AI" into its cloud suite.
This transition hasn’t been without its bumps. Some of SAP’s on-premises customers expressed frustration with its perceived focus on cloud-only solutions. Instead of appeasing these grievances, SAP doubled down, offering discounts to entice these customers towards the cloud, essentially making AI the carrot dangling in front of the cloud stick. Investment management company Ave Maria World Equity Fund highlighted SAP’s transition from a perpetual license model to a SaaS model as a key driver for its impressive Q1 2024 performance, citing an expanded total addressable market (TAM) and promising margins.
Gartner chief forecaster John-David Lovelock attributes the success of SAP and similar companies to ongoing digital business transformation efforts that began in 2021, a trend further fueled by the preference for cloud over on-premises solutions as well as the need for upgrades and expansions.
Oracle’s Cloud Ascent
Oracle follows a similar trajectory, with its valuation exceeding $385 billion, a 20% jump from last year. Its "AI-fueled cloud growth", coupled with the long-term transition from on-premises to the cloud, mirrors SAP’s success. Oracle, in fact, has achieved a significant milestone, surpassing its total license support revenue with its cloud revenue (including both SaaS and IaaS) for the first time.
Oracle CEO Safra Catz emphasized this shift in the company’s Q4 earnings call, emphasizing the growing demand for training AI large language models on the Oracle Cloud. This demand has led to Oracle signing "the largest sales contracts in our history," according to Catz. Partnerships with tech giants like Microsoft, Google, and OpenAI, which are aggressively seeking cloud infrastructure to power AI projects (such as OpenAI’s use of Oracle’s cloud to train ChatGPT), further solidify Oracle’s position in this evolving landscape.
IBM’s Rejuvenation
IBM, a company born in 1911 as the Computing-Tabulating-Recording Company, has undergone a remarkable transformation. After decades of being a hardware company known for its mainframes and PCs, "Big Blue" transitioned into a software and services giant, eventually spinning off its legacy infrastructure business as Kyndryl in 2021.
IBM’s cloud journey began in 2007 with Blue Cloud, followed by the launch of IBM Cloud and strategic acquisitions like Red Hat. Notably, IBM has aggressively embraced AI, starting with IBM Watson and culminating in a multitude of AI services, including the launch of Watsonx, a platform for training, tweaking, and deploying AI models.
This strategy has been paying off, with demand for AI accelerating and IBM seeing bookings for Watsonx and generative AI double from the third to the fourth quarter, as stated by IBM CEO Arvind Krishna. While its Q1 2024 financials showed a mixed bag of successes and missed expectations, analysts remain optimistic about IBM’s AI investments and its continued focus on infrastructure software. Goldman Sachs, for instance, has awarded IBM a "buy" rating, citing these investments as a key driver for growth.
Beyond the Big Three
While SAP, Oracle, and IBM are prominent examples, the resurgence of legacy software companies isn’t limited to them. Intuit, a 41-year-old financial software company, recently hit a valuation of $187 billion, riding the AI wave through continued investments in AI and cloud-based solutions. Similarly, Adobe, founded in 1982, is experiencing a significant valuation surge, with its Q1 and Q2 revenues hitting record highs, powered by its AI-driven cloud offerings.
The Wider Context
This surge in legacy software companies’ valuations comes at a time when investors have limited options for making bets on new technology. The stagnant IPO market and the impact of private equity acquisitions have created a landscape where these established giants are seen as safe havens for investment.
As Ray Wang, founder and principal analyst at Constellation Research, points out, the limited competition in the market, with oligopolies and duopolies dominating, further fuels this trend. The lack of emerging startups successfully scaling to compete with the incumbents creates a vacuum that legacy software companies are filling.
AI and the Future
While these companies are benefiting from AI, their success isn’t solely driven by it. Their existing market presence, stable customer base, and substantial resources, coupled with their strategic acquisitions, provide a strong foundation for navigating the AI landscape. They are better positioned to capitalize on the mainstream adoption of AI, which is heavily reliant on cloud infrastructure.
However, it’s important to acknowledge that we might be in an AI bubble. Gartner’s "hype cycle" suggests that as early experiments and implementations fail to deliver on their lofty promises, a "trough of disillusionment" could be looming. This could present challenges for some of those multi-billion dollar generative AI startups.
Despite this, Lovelock argues that traditional software markets remain robust, with combined annual revenues exceeding $1 trillion in 2024. The rapid growth of AI has somewhat obscured the strong growth of these legacy software giants, but they are well-positioned to benefit from the long-term adoption of AI.
The future of the tech landscape is undoubtedly intertwined with AI. While the current focus might be on AI-driven innovation, the "dinosaurs" of the software industry are far from extinct. Their decades of experience, established customer bases, and aggressive adaptation to the changing tides of technology position them as formidable contenders in the AI-powered future. The next chapter of this story will undoubtedly reveal whether these legacy players can truly embrace the AI revolution and solidify their dominance in the years to come.
